Topic 4 Quiz - Part 2 Answers

Use The following information for the following problems

You are considering two investments in stock; an investment in “EuroBioTech Corp.” or “Wet Sprocket Inc.”

EuroBioTech Corp.                         Wet Sprocket Inc.

            (Beta = 1.5)                                             (Beta = 0.9)

Probability     Stock Return                  Probability     Stock Return

        0.3              16%                             0.2                 9%     

        0.4               8%                              0.6                 4%

        0.3               0%                              0.2                 1%

1.     What is the expected return on EuroBioTech?  For Wet Sprocket?

• Click her for answer:

  • Expected Return EuroBioTech  = .0800

  • Expected Return Wet Sprocket = .0440

  • Expected Return equation:

  •  

  •  

2.     What is the standard deviation of the possible returns on EuroBioTech?  For Wet Sprocket?

• Click her for answer:

  • Standard Deviation EuroBioTech  = .061968

  • Standard Deviation Wet Sprocket = .035676

  • Standard Deviation Equation

  •   

  •                           Where P_i  = 1/N

  •  

 

3.     If the stock of EuroBioTech Corp. has a correlation coefficient of -.56 with the market portfolio and the stock of Wet Sprocket, Inc. has a correlation coefficient of +.75 the market portfolio, which stock will create a greater diversification effect when added to a small portfolio of randomly chosen stocks?

• Click her for answer:

  • EuroBioTech since its return is negatively correlated with the other stocks.

4.     Which stock is riskier if you use a relative measure of total risk?

• Click her for answer:

  • relative measure of total risk is the coefficient of variation

  • calculated as Standard Deviation / Expected Return

  • CoV of EuroBioTech = .7746 = (.061968/.0800)

  • CoV of Wet Sprocket = .8108 = (.035676/.0440)

  • Wet is riskier

6.       Which stock has the lowest systematic risk?

• Click her for answer:

  • Beta is our measure of systematic risk

  • Wet Sprocket's Beta of 0.9 is lower and has the lower systematic risk

7.      Which stock has the greatest absolute total risk?

• Click her for answer:

  • variance or standard deviation are the measures of absolute total risk

  • EuroBioTech has the greatest absolute total risk

9.     If you combine the two stocks into a portfolio with equal weights for each, what is the expected return on the portfolio?

• Click her for answer:

  • PF return = (.5)(.0800) + (.5)(.0440) = .0620 = 6.2%

10.   If you combine the two stocks into a portfolio with 40% invested in EuroBioTech and 60% invested in Wet Sprocket, what is the expected return on the portfolio?

• Click her for answer:

  • PF return = (.4)(.0800) + (.6)(.0440) = .032 + .0264 = .0584 = 5.84%

11.   If you combine the two stocks into a portfolio with 40% invested in EuroBioTech and 60% invested in Wet Sprocket, what is the Beta of the portfolio?

• Click her for answer:

  • PF beta = (.4)(1.500) + (.6)(.9000) = .60 + .54 = 1.14

=====================================================================